Aussie could remain high despite cash rate slash

The Reserve Bank of Australia this week cut the official cash rate to an historic low of 2.75 per cent.
Photo: Bloomberg

by
Paul Bloxham

The Reserve Bank of Australia cut the cash rate to its lowest level in over 53 years this week. This is extraordinary given that the economy is still growing at a close to trend pace and the unemployment rate is around 5.5 per cent. But when inflation is low it seems there is little to stand in its way. As the RBA noted in its post-board meeting statement, inflation is consistent with the target and “if anything, a little lower than expected".

Nonetheless, a new low for the cash rate brings with it new risks. To understand these, it helps to first determine why the RBA cut it this week.

In our view, a key reason for the cut was the high Australian dollar. The high currency helps explain both why the RBA has been able to cut interest rates – the high Aussie has held down inflation – and why it saw the need to cut rates in the first place. That is, to support growth in the internationally exposed sectors, including manufacturing. A secondary aim of the cut therefore seems to have been to put some downward pressure on the local currency.

But the challenge here is that the relationship between the Australian dollar and interest rates is fairly loose. The RBA itself has noted this in the past. Much of the currency’s strength reflects conditions in the rest of the world rather than conditions at home. Indeed, the key drivers of the high Australian dollar have been the sheer quantity of money being printed in the developed economies, driving a search for yield, and the high level of commodity prices relative to history. Neither of these is likely to change anytime soon.

So, even with the cash rate at its lowest level in modern history, the Australian dollar could remain stubbornly high.

Down, down far from foolproof

One option may be to cut rates even further to put downward pressure on the currency. Markets are now pricing in another 40 basis points of cuts by mid-next year. But this race to the bottom is a risky strategy.

Cheap money can lead to asset price bubbles. In Australia, equity and bond prices are already rising strongly, and the housing market is picking up. Lower rates risk further exacerbating these trends. While in the short run this may be good for growth, as rising asset prices encourage spending, there is a risk that low interest rates will lead to asset misallocation.

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These risks become most acute when interest rates are left at low levels for long periods – as seems to be implied by the current market pricing of the Australian cash rate. This is because households and businesses grow used to the idea that rates are low, and this affects their expectations for future interest rate settings. If they believe interest rates will stay low, they are prepared to take more risks.

What the RBA is seeking is quality growth in the economy. As the mining investment story slows down the central bank is looking to support growth in the non-mining sectors.

To a large degree this is already happening. Even the RBA’s post-meeting statement acknowledged this. They cited “strengthening in consumption" and “firming in dwelling investment", as well as prospects for “some increase in business investment outside the resources sector".

In our view, this week brought more signs that monetary policy is already gaining traction. The volume of retail spending rose 2.2 per cent in the first quarter, its strongest quarter-on-quarter growth in six years. Housing prices are rising and auction clearance rates were at three-year highs last weekend. March data showed that Australia had its first trade surplus since December 2011, as the export phase of the mining boom has started to ramp up. The timely data seem consistent with a strong first quarter GDP print – due to be published in early June – led by household consumption and exports.

Given that monetary policy is already working, the RBA may not need to cut rates further. However, the rates outlook may depend more than usual on how successful the RBA is in pushing the Australian dollar lower. If the RBA succeeds in this, it will also lift inflation.

Conversely, if there are further cuts from here, as markets are pricing in, it may create bubbles down the track. Cheap money is not the solution to all that ails an economy. A quick look across developed economies reminds us of this.